Follow The Banks If You Want To Make Money

When times are good, banks can make money – lots of it. But when times are bad, banks can get hit. That’s just the way things go. It’s not that bankers never learn from their past mistakes. It’s because they lend aggressively when the economy is booming. But they can get caught out, when the economy dips. Thing is, when times are looking good, central bankers like to crank up their lending rates. It’s quite simple – in a strong economy, where wages are rising, then consumer prices could rise too. But central bankers want to be ahead of inflation….

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When times are good, banks can make money – lots of it. But when times are bad, banks can get hit. That’s just the way things go.

It’s not that bankers never learn from their past mistakes. It’s because they lend aggressively when the economy is booming. But they can get caught out, when the economy dips.

Thing is, when times are looking good, central bankers like to crank up their lending rates.

It’s quite simple – in a strong economy, where wages are rising, then consumer prices could rise too. But central bankers want to be ahead of inflation. So, they try to ensure that their interest rates stay above the pace of rising prices.

Up and down

So, interest rates can both go up and go down.

Whether we are savers, borrowers, home owners or retirees, interest rate movements affect us all. But they matter most to banks.

They make the bulk of their income from the difference in the interest rates they charge borrowers and the rates they pay savers. This is known as the net interest margin.

The higher that interest rates rise, the wider the margin expands, and the greater can be the net interest income for banks.

Survival instinct

However, our fears over many banks’ ability to survive the aftermath of the financial crisis were reflected in their share prices.

Some of us thought that they were all off to hell in a handcart. As the financial crisis unfolded, the median market value of banks plunged by nearly two-thirds.

It didn’t seem to matter where the banks were located. They were tarred with the same brush. OCBC(SGX: O39) shares shed 40%.

It was an awful time to hold bank shares. But it wasn’t too bad a time to be a banker.

In the balance

While the market values of banks were being depressed by investor pessimism, the same cannot be said of their tangible book values.

After an initial dip, their book values improved gradually. In other words, shareholder equity in banks were rising, even though the market value of banks were not. The tangible book value of Malayan Banking Berhad (KLSE: 1155.KL) improved 7%.

But the market, it would seem, were ignoring the balance sheet improvements.

Many banks that had previously been valued at more than twice their tangible book value slumped to valuations that would suggest they were on the brink of collapse. The price to book value of United Overseas Bank(SGX: U11) more than halved from 2.5.

By the book

The price-to-book valuations of banks have now recovered. But they still look conservative, given that the global economy is improving, gross loans are on the rise and interest rates are hardening.

It is possible that as bank profits increase, then so too could their book values.

In hindsight, a good time to have bought bank shares would have been when they were valued at below their book values. But it is not easy to invest when news of the unfolding financial crisis was so dire.

News and noise

Admittedly, provisions over bad debts did spike in the aftermath of the crisis. But so too did their loan books. Consequently, non-performing loans as a proportion of total lending were not that bad.

They had jumped from around 0.2% before the financial crisis to 0.6% in the two years following. They are now roughly back to where they were before the financial debacle.

The lesson is clear. When we invest, it is often easy to let our hearts rule our head. As a result, every financial number that is talked about seems to be equally important.

But not everything that can be counted, counts. It is important to separate the news from the noise.

A version of this article first appeared in the Business Times.

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